MCLR: A touch of relief

The norm so far has been that banks reduce lending rate after the Reserve Bank of India announces its monetary policy. It was different this time, as a few banks announced rate cuts even before the RBI had announced its monetary policy on April 5. This is because of the marginal cost of funds-based lending rate or MCLR, to which all new loans, sanctioned on or after April 1, 2016, will now be linked. It is a welcome move as the new interest rate calculation is expected to be more sensitive to policy changes. Under the earlier base rate method, despite the frequent rate cuts by the RBI, banks were unable to transmit the entire benefit to borrowers.

How is the new formula different?

Earlier, banks used to calculate the base rate on the basis of the average cost of raising funds. MCLR is calculated on the basis of the marginal (incremental) cost of funds and tenure premium (it's higher for loan commitments with longer tenures).

The actual lending rate is MCLR plus the spread, which banks will determine after factoring in their business strategy and the credit risk of the borrower.

The RBI has asked banks to set at least five MCLR rates-overnight, one-month, three-month, six-month and a year.

Several banks, such as SBI and ICICI, are calculating their lending rate on the MCLR for a year.

To whom does it apply?

The new formula applies only to new loans, not to the entire loan book of the bank.

Existing borrowers will still be linked to the base rate. However, one can request their bank to switch to MCLR.

How does it affect you?

Under MCLR, if you have taken the loan on April 1, 2016, and if your bank cut rates on April 6, 2016, then you will get the benefit only after a gap of one year.

However, you will be protected if rates go up. New rates would be applicable only when they are due for a reset.

MCLR would create more transparency in loan pricing and interest rates.

On the downside, if banks don't cut term deposit rates, passing on benefits might become a challenge for them.

With RBI cutting repo rates on April 5, banks will have to pass on the benefit to borrowers sooner or later.

What should one do?

MCLR rates are expected to be lower than the existing base rates for one year. In a falling interest rate scenario, experts say, the MCLR methodology will benefit borrowers as the reduction in repo rates will reflect in their interest rates.

However, in an ascending interest rate scenario, the borrower will have to bear the pain of rising EMIs.